Investing Lesson 4: Income Statement Analysis

Introduction

Purpose of the Income Statement

The primary purpose of the income statement is to report a company's earnings to investors over a specific period of time. Years ago, the income statement was referred to as the Profit and Loss (or P&L) statement, and has since evolved into the most well-known and widely used financial report on Wall Street. Many times, investors make decisions based entirely on the reported earnings from the income statement without consulting the balance sheet or cash flow statements (which, while a mistake, is a testament to how influential it is).

Using Income Statement Analysis to Calculate Expenses, Earnings, Financial Ratios and Profit Margins

To a serious investor, income statement analysis reveals much more than a company's earnings. It provides important insights into how effectively management is controlling expenses, the amount of interest income and expense, and the taxes paid. Investors can use income statement analysis to calculate financial ratios that will reveal the rate of return the business is earning on the shareholders' retained earnings and assets (in other words, how well they are investing the money under their control). They can also compare a company's profits to its competitors by examining various profit margins such as the gross profit margin, operating profit margin, and net profit margin.

Beginning our Analysis of the Income Statement

As we progress through this series of investing lessons, you must remember John Burr William’s basic truth that a business is only worth the profit that it will generate for its owners from now until doomsday, discounted back to the present, adjusted for inflation. The income statement is the “report card” of those earnings, which ultimately determine the price you should be willing to pay for a business.

Sit back in your chair, take out a copy of an annual report or 10K, flip to the consolidated income statement for the most recent year, and let’s begin working through it. In the end, I think you’ll be surprised by how much you’ve learned. Towards the end of this lesson, we will actually work through Abercrombie & and Brown Safety's income statements. As always, there will be quiz following the lesson. You should be able to pass without missing more than two questions.

Sample Income Statement

The best way to learn to read an income statement is to begin by looking at a real world example. In this case, I'm going to take an old income statement from Microsoft because it is relatively simple, enough time has passed for us to look at the figures in retrospect, and you can look at it to get an idea of what an ordinary income statement looks like. You can see this sample at the bottom of this page. You may want to print it for reference as you work your through this lesson.

It's important to note that not all income statements look alike, although they necessarily contain much of the same information. As we work our way through various income statements, you will inevitably find they are much simpler and comparable than may appear at first glance.

Sample Income Statement

MicrosoftIncome Statement

Fiscal year 2001 2000 1999

Total Revenue $28,365,000,000 $$25,296,000,000 $$22,956,000,000

Cost of Goods Revenue $5,191,000,000 $3,455,000,000 $3,002,000,000

Gross Profit $23,174,000,000 $21,841,000,000 $$19,954,000,000

Operating Expense

Research and Development $4,307,000,000 $4,379,000,000 $3,775,000,000

Selling, General, and Administrative Expenses

$6,957,000,000 $5,742,000,000 $5,242,000,000

Non Recurring N/A N/A N/A

Other Operating Expenses N/A N/A N/A

Operating Income

Operating Income $11,910,000,000 $11,720,000,000 $10,937,000,000

Total Other Income and Expenses Net ($397,000,000) ($195,000,000) $3,338,000,000

Earnings Before Interest and Taxes $11,513,000,000 $11,525,000,000 $14,275,000,000

Interest Expense N/A N/A N/A

Income Before Taxes $11,513,000,000 $11,525,000,000 $14,275,000,000

Income Tax Expense $3,684,000,000 $3,804,000,000 $4,854,000,000

Equity Earnings or Loss Unconsolidated Subsidiary

N/A N/A N/A

Minority Interest N/A N/A N/A

Net Income from Continuing Operations $7,829,000,000 $7,721,000,000 $9,421,000,000

Nonrecurring Events

Discontinued Operations N/A N/A N/A

Extraordinary Items N/A N/A N/A

Effect of Accounting Changes N/A ($375,000,000) N/A

Other Items N/A N/A N/A

Net Income $7,829,000,000 $7,346,000,000 $9,421,000,000

Total Revenue or Total Sales

Total Revenue or Total Sales The first line on any income statement is an entry called total revenue or total sales. This figure is the amount of money a business brought in during the time period covered by the income statement. It has nothing to do with profit. If you owned a pizza parlor and sold 10 pizzas for $10 each, you would record $100 of revenue regardless of your profit or loss.

The revenue figure is important because a business must bring in money to turn a profit. If a company has less revenue, all else being equal, it's going to make less money. For startup companies and new ventures that have yet to turn a profit, revenue can sometimes serve as a gauge of potential profitability in the future.

Many companies break revenue or sales up into categories to clarify how much was generated by each division. Clearly defined and separate revenues sources can make analyzing an income statement much easier. It allows more accurate predictions on future growth. Starbucks' 2001 income statement is an excellent example (see Table STAR-1 at the bottom of this page).

As you see in the chart, sales at Starbucks come primarily from two sources: retail and specialty. In the annual report, management explains the difference between the two several pages before the income statement. "Retail" revenues refer to sales made at company-owned Starbucks stores across the world. Every time you walk in and order your favorite coffee, you are adding $3 to $5 in revenue to the company's books. "Specialty" operations, on the other hand, consists of money the company brings in by sales to "wholesale accounts and licensees, royalty and license fee income and sales through its direct-to-consumer business". In other words, the specialty division includes money the business receives from coffee sales made directly to customers through its website or catalog, along with licensing fees generated by companies such as Barnes and Nobles, which pay for the right to operate Starbucks locations in their bookstores.

Cost of Goods Sold - COGS

Cost of Revenue, Cost of Sales, Cost of Goods Sold (COGS) Cost of goods sold (COGS for short) is the expense a company incurred in order to manufacture, create, or sell a product. It includes the purchase price of the raw material as well as the expenses of turning it into a product. Cost of goods sold (COGS) is also known as cost of revenue or cost of sales.

Going back to our pizza parlor example, your cost of goods sold (COGS) include the amount of money you spent purchasing items such as flour and tomato sauce.

The cost of goods sold per dollar of sales is going to be different depending upon the type of business you own or in which you buy shares of stock. A licensing company or law firm will have virtually no cost of goods sold because they are selling a service and not a tangible product.

Before you invest in a business, you'll want to research the industry you are examining and find out what is considered "good". For corporations that drill for oil, for instance, one of the most important figures you need to consider is the cost per barrel to get the oil out of the ground. This is, in effect, the cost of goods sold for the oil company. If one firm can get crude at far lower costs than its competitors, it has a distinct advantage and will result in more profit flowing to the owners or shareholders.

Another thing you want to try and figure out is how exposed a company is to a particular input cost. For Southwest Airlines, the cost of jet fuel (and thus, oil) is the most important cost the company has. For Starbucks or Folgers, now a division of J.M. Smucker's, it's coffee. For Coca-Cola, sugar prices are extremely important. One of the reasons some investors are extremely successful is because they know the exact relationship between profits and cost of goods sold. It's been noted that Warren Buffett knows the per 12 ounce can profitability figures for a serving of Coca-Cola and watches sugar prices regularly. If you were a small candy company, or even a giant like Coke, periods of time such as April to July of 2009 would have been hard for your business as sugar prices nearly doubled without warning. As an investor, you need to be aware of the risk a business faces due to unexpected higher cost of goods sold regardless of if you are buying shares of stock, purchasing a local business, or launching your own start-up.

Gross Profit

Gross Profit

The gross profit is the total revenue subtracted by the cost of generating that revenue. In other words, gross profit is sales minus cost of goods sold. It tells you how much money a business would have made if it didn’t pay any other expenses such as salary, income taxes, office supplies, electricity, water, rent, etc.

When you look at an income statement, GAAP rules require that gross profit be broken out and clearly labeled as its own line so you can't miss it. Still, you should know how to calculate it for yourself so here is the formula:

Total Revenue - Cost of Goods Sold (COGS) = Gross Profit

The gross profit figure is important because it is used to calculate something called gross margin, which we will discuss in a moment. In fact, you can't really look at gross profit on its own and know if it is "good" or "bad", making the gross margin even that much more important.

An Example of Gross Profit from One of My Companies

To help illustrate the concept of gross profit, I'll give you an example from one of the businesses in which I have a substantial ownership stake. The company is called Kennon Home Accessories. It sells a lot of luxury shaving sets both online and through its flagship retail store just north of Kansas City. If a customer purchases an imported British luxury shaving set for $315, our cost of goods sold would typically be $160 for the set itself, $20 for various merchant fees, service charges, and bank processing costs, and $20 for shipping and handling into our retail store.

This results in revenue of $315 - cost of goods sold of roughly $200 for a gross profit of $115 per every shaving set sold. If we were to drop the price 20% for a sale, the calculation would change to $252 revenue - $200 costs of goods sold = $52 gross profit. The $115 in the first case, or the $52 in the second, is the money we have available to pay our sales associates, taxes, office supply expense, and computer costs. The higher the gross profit, the more money we have for expansion, salaries, or dividends to shareholders.

Calculating Gross Profit Margin

Gross Profit Margin

Although we are only a few lines into the income statement, we can already calculate our first financial ratio. The gross profit margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue / sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.)

To calculate gross profit margin, use this formula: Gross Profit ÷ Total Revenue

Calculating Sample Gross Profit Margin

For illustration purposes, let's calculate the gross profit margin of Greenwich Golf Supply (a fictional company) using its income statement. You will find the statement at the bottom of this page in Table GGS-1.

Assume the average golf supply company has a gross margin of 30%. (You can find this sort of industry-wide information in various financial publications, online finance sites such as moneycentral.com, or rating agencies such as Standard and Poors).

We can take the numbers from Greenwich Golf Supply's income statement and plug them into our formula:

$162,084 gross profit ÷ $405,209 total revenue = 0.40

The answer, .40 (or 40%), tells us that Greenwich is much more efficient in the production and distribution of its product than most of its competitors.

Gross Profit Margin Over Time

The gross margin tends to remain stable over time. Significant fluctuations can be a potential sign of fraud or accounting irregularities. If you are analyzing the income statement of a business and gross margin has historically averaged around 3%-4%, and suddenly it shoots upwards of 25%, you should be seriously concerned. For more information on warning signs of accounting fraud, I recommend Howard Schilit's Financial Shenanigans: 2nd edition: How to Detect Accounting Gimmicks and Fraud in Financial Reports.

Table GGS-1

Greenwich Golf SupplyConsolidated Statement of Earnings - Excerpt

In thousands except earnings per share

Fiscal year ended Sept 30, 2007 Oct 1, 2008

Total Revenue $405,209 $315,000

Cost of Sales $243,125 $189,000

Gross Profit $162,084 $126,000

First Three Lines of the Income Statement

Putting It Together Thus Far:

We've actually covered a lot of ground. Here's an example to help reiterate and clarify everything we've discussed about the income statement.

If the owner of an ice cream parlor purchased 10 gallons of vanilla ice cream for $2 per gallon, and sold each of those gallons to her customers for $5, the first three lines on her income statement would look something like this:

Total Revenue $50 (The total revenue is the amount of money rung up at the cash register. The owner sold 10 gallons of vanilla ice cream to her customers for $5 per gallon. 10 gallons x $5 a gallon = $50.)

Cost of Goods Sold $20 (The cost of goods sold was 10 gallons x $2 per gallon = $20)

Gross Profit $30

(The total revenue subtracted by the cost to earn that revenue is $30. Before taxes, and other expenses, this is the ice cream parlor's gross profit.)

Gross Margin: .6 (or 60%)

The gross margin of 60% means that for every $1 the company generates in sales, it is going to be left with $0.60. That sixty cents must be enough to cover all of the other expenses such as payroll, rent, taxes, freezers, cash registers, aprons, security systems, and accounting fees, just to name a few, before the owner will receive any dividend income from the business. Those other expenses are known as operating expenses and that's what we're going to examine on the next page.

Operating Expense on the Income Statement

Operating Expense

The next section of the income statement focuses on the operating expenses that arise during the ordinary course of running a business. Operating expense consists of salaries paid to employees, research and development costs, legal fees, accountant fees, bank charges, office supplies, electricity bills, business licenses, and more.

The general rule of thumb is that if an expense doesn't qualify as a cost of goods sold, meaning it isn't directly related to producing or manufacturing a good or service, it goes under the operating expense section of the income statement. There are several categories, the biggest of which is known as Selling, General, and Administrative Expense, but we'll get to that in a few pages.

Whether you are a new investor trying to study a company's annual report and 10K, or a business owner examining your operations or considering buying or starting a new undertaking, understanding the role of operating expenses is vital to your success.

The biggest challenge to controlling operating expenses is a risk known as agency cost. It is the inherent conflict between owners and managers. Those that work in the business are always going to want nicer offices, more secretaries, better facilities, faster computers, free lunches, or whatever else they can imagine. These are easier to control if you have a small business but your options are limited if you own shares in a large corporation.

You'll also find that some companies purposely chose to run higher expense ratios than their competitors. One major, well-known bank makes an intentional choice to run 10% to 15% higher operating expenses, and thus lower profit margins, to keep the branches fully staffed. They believe that by making banking as convenient as possible and avoiding long lines, the improved customer service will cause more of their clients to keep a larger portion of their household's accounts with them. Their goal is to eventually become a one-stop shop so that you can do your banking, manage your credit cards, open a brokerage account, or get insurance, all on an integrated statement. Only you, as the investor, can decide whether you think the plan is intelligent and the higher operating expense are worth it.

In general, you want to work with managements that strive to keep operating expense as low as possible while not damaging the underlying business.

Research and Development Costs - R&D

Research and Development

R&D costs can range from nothing to billions of dollars, depending upon the type of business you are analyzing. Unlike many other costs (such as income taxes), management is almost entirely free to decide how should be spent on research and development. In 2001, Eli Lilly, one of the world's largest pharmaceutical companies, plowed nearly 26% of the total gross profit back into R&D.

How much should a company spend on R&D? It depends. In highly creative and fast-moving industries, the amount of money spent on the research and development budget can literally determine the future of the business. If Eli Lilly stopped funding the development of new drugs, its future profitability would suffer, causing a perhaps permanent decline in earnings. In such cases, it may be appropriate to

compare the level of R&D funding to profitability over time, as well as to the percentage of gross profit competitors spend on research and development.

Selling, General and Administrative Expenses - SGA

Selling General and Administrative Expenses (SGA)

SGA expenses consist of the combined payroll costs (salaries, commissions, and travel expenses of executives, sales people and employees), and advertising expenses a company incurs. High SGA expenses can be a serious problem for almost any business. A good management will often attempt to keep SGA expenses limited to a certain percentage of revenue. This can be accomplished through cost-cutting initiatives and employee lay-offs.

There have been several cases in the past where bloated selling, general and administrative expenses have literally cost shareholders billions in profit. According to Roger Loweinstein, in the 1980's, ABC (later merged with CAP Cities, then bought by Disney) was spending $60,000 a year on florists, as well as providing stretch limos and private dining rooms for its executives. It was the shareholders who were footing the bill. (On a related note: at the same time these ABC executives were squandering shareholders' capital, they were artificially padding earnings by selling the original Jackson Pollack and Willem de Kooning paintings the network owned!)

SGA Expenses and Fixed vs. Variable Cost Structure

There is a big difference between a company that has a variable cost structure and one that has a fixed cost structure. A company with high fixed expenses is said to have high operating leverage because the company loses money up to a break-even point and then makes a lot of profit beyond that level. A perfect example is a McDonald's franchise. Due to the high initial investment in land, building, cooking equipment, restaurant seating, fixtures, and other costs, you may have to do, say, $800,000 to $1,000,000 or more to breakeven. Beyond that point, your costs are covered so you generate far higher profits. That's why a business can fail if sales fall from $2,000,000 to $800,000, even though it is still a decent size by small business standards.

A variable cost structure is one in which the selling, general and administrative expenses keep pace with sales. Think of a furniture importer that has almost no expenses except for a 15% commission paid to independent road salesmen. If sales fall, costs fall in line, protecting the business and shareholders. Companies with highly variable cost structures are said to have low operating leverage.

Goodwill and Amortization Charges

Goodwill and other Intangible Asset Amortization Charges

You already learned what goodwill was in Investing Lesson 3 - How to Analyze a Balance Sheet. A quick reminder in case you forgot: Goodwill is used to show the price in excess of the assets one business pays when it acquires another business. If that sentence scared you, calm down and let me explain. Say your pizza parlor wants to buy a competitor's pizza shack. Anything you pay in excess for the current value of the assets such as real estate, food equipment, appliances, tables, chairs, or other goods, gets put on your balance sheet as goodwill. For more than one hundred years, small business owners often refer to goodwill as "blue sky".

In the past, companies were required to charge a portion of goodwill to the income statement, reducing reported earnings. The theory made sense on the surface: If you bought any asset, you had to depreciate it so why, then, wouldn't you have to do the same when you bought an entire company?

For all intents and purposes, these goodwill charges were ignored by the investor because, unlike buying assets that were needed to operate, acquiring a competitor or merger likely increased your profits if done wisely. The goodwill charges were causing managers to report lower earnings, which was against the accounting goal of providing an accurate picture of economic reality.

Changes in the Accounting Rules for Goodwill

In June 2001, the Financial Accounting Standards Board (FASB), the folks who make accounting rules in the United States by determining GAAP, changed the guidelines, no longer requiring companies to take these goodwill and amortization charges. Instead, the company was required to periodically determine, through cash-flow analysis and other means, whether the goodwill was impaired. In practical terms, this meant that the goodwill would sit on the balance sheet forever unless something happened to the acquired business that caused management to realize they overpaid. In the event they did overpay, they would record a goodwill expense on the income statement, causing reported profits to fall. The goodwill "asset" could then be removed from the balance sheet.

The one exception to this new goodwill policy was intangible assets that do not have indefinite lives, such as patents. These will need to continue to be amortized off as an expense because when the patent expires, it is effectively worthless so it would be misleading to list it on the balance sheet as an asset. In simple terms, if the pizza shack you bought had a licensing agreement with a local sports team that ran out in five years, you would have to continue to charge that asset off on the income statement until it reached $0 at the end of the five years.

The most important thing for you to know when you look at goodwill is that it is a non-cash charge. That means that if a company has a goodwill expense of $10 million, not a penny is coming out of headquarters in most cases because it is just representing a loss that has already occured. If the pizza shack you bought went bankrupt three years from now after the building burned to the ground, you would record a goodwill charge and your profits will be lower. The money you spent for the building was paid out three years before when you bought the place, not when the goodwill charge hit the income statement.

Extraordinary and Nonrecurring Items or Events

Non-Recurring and Extraordinary Items or Events

You own a successful dry cleaning business. Out of the blue, a tornado sweeps away your storefront and shuts you down for a few months. Your insurance will pay to rebuild but it will take time and there are other costs involved. Is the tornado expense a regular, expected occurance? Does it really hurt the value of your business? Of course not.

In the unpredictable world of business, events will arise that are not expected and most likely not occur again. These one-time events are separated on the income statement and classified as either non-recurring or extraordinary. There is a difference between the two, which I'll explain in a moment.

These two categories allow investors to more accurately predict future earnings. If, for instance, you were considering purchasing a gas station, you would base your valuation on the earning power of the business, ignoring one-time costs such as replacing the station's windows after a thunderstorm. Likewise, if the owner of the station had sold a vintage Coke machine for $17,000 the year before, you would not include it in your valuation because you had no reason to expect that profit would be realized again in the future.

The Difference Between Non-Recurring and Extraordinary Events on the Income Statement What is the difference between non-recurring and extraordinary events?

Non-Recurring Event: A non-recurring eventis a one-time charge that the company doesn't expect to encounter again. An extraordinary item is an event that materially* affected a company's finance and needs to be thoroughly explained in the annual report or SEC filings.

Extraordinary Event: Extraordinary events can include costs associated with a merger, or the expense of implementing a new production system (as McDonald's did in the late 1990's with the Made for You food preparation system).

There is an important distinction between the two categories: Non-recurring items are recorded under operating expenses, while extraordinary items are listed after the net line, after-tax.

* The term material is not specific. It generally refers to anything that affects a company in a meaningful and significant way. Some investors try to put a number on the figure,

saying an event is material if it causes a change of 5% or more in the company's finances.

Accounting for Extraordinary and Nonrecurring Items or Events

Accounting for Extraordinary and Non-Recurring Items or Events in Your Analysis

When calculating a company's earning-power, it is best to leave one-time events out of the equation. These events are not expected to repeat in the future, and doing so will give you a better idea of the earning power of the company.

If you are attempting to measure how profitable a business has been over a longer period, say five or ten years, you should average in the one-time events to paint a more accurate picture. For example, if a company purchased a building for $1 million in 1990, and sold it for $10 million ten years later in 2000, it is improper to consider the company earned $9 million in profit in the year 2000. Instead, the extraordinary income, in this case, $9 million, should be divided by the number of years it accrued (10 years - 1990 to 2000). Thus, $9 million in extraordinary income divided by 10 years = $900,000 in real estate profits per year.

Although the income statement will reflect a $9 million one-time profit for the business, the investor should restate the earnings during their analysis by going back and adding $900,000 to each of the years between 1990 and 2000. This will increase the accuracy of a trend line. Since the asset was quietly appreciating during this time, it should be reflected.

However, going forward, when attempting to value the business, you shouldn't include that $900,000 extra income per year because it won't be there in the future. That is why you cannot rely solely on past financial statements to figure out what you should pay for a business or stock. You have to be intelligent and use your understanding of what is really going on with a company.

Operating Income and Operating Profit Margin

Operating Income and Operating Profit

Operating income, or operating profit as it is sometimes called, is the total pre-tax profit a business generated from its operations. It is what is available to the owners before a few other items need to be paid such as preferred stock dividends and income taxes (don't worry - we'll cover all of those other things later in this lesson).

Operating income can be used to gauge the general health of a company's core business or businesses. All else being equal, it is one of the most important figures you will ever need to know. The reason is straightforward and intuitive: Unless a firm has a lot of assets that it can sell, any money that will flow to shareholders is going to have to be generated from selling something such as a product or service.

If a company is experiencing declining operating income, there will be less money for owners, expansion, debt reduction, or anything else management hopes to achieve. This is one of the reasons that it is so closely watched by lenders and shareholders. In fact, operating income is used to calculate the interest coverage ratio and operating margin.

Calculating Operating Income Operating Income = Gross Profit – Operating Expenses

Operating Margin (or Operating Profit Margin) The operating margin is another measurement of management’s efficiency. It compares the quality of a company’s activity to its competitors. A business that has a higher operating margin than others in the industry is generally doing better as long as the gains didn't come by piling on debt or taking highly risky speculations with shareholders' money.

The most common reason for high operating margins relative to competitors is a low-cost operating model, which means that a company can deliver merchandise or services to customers at much cheaper prices than competitors and still make money. The classic example is Wal-Mart, which is able to get everything from toothpaste to socks into its store at far lower prices due to the efficiency of its warehouse distribution system. I explained the beauty of a low-cost operating model in The Perils of Commodity-Like Businesses. They are the few, exceptional cases when you can make a lot of money in an otherwise unattractive industry.

Calculating the Operating Margin To calculate the operating margin, divide operating income by the total revenue.

Operating Income ÷ Sales = Operating Margin

Just as you learned with the gross profit margin, what is considered "good" depends on the industry. There is one extremely important thing you must learn, though. I'm serious. Stop what you're doing and focus on this statement: The most important figure is not operating income. It is return on unleveraged equity. That may not make sense to you now, but by the end of the lesson it will. It is possible (though unlikely) for a business that generates 3% operating margins to be more profitable for owners than a business that has 20% operating margins. Again, don't worry about the reason; we'll get to it later. Just realize it. Memorize it. Write it down on some paper. It's that important.

Interest Income and Expense

Interest Income

Companies sometimes keep their cash in short-term deposit investments such as certificates or deposit with maturities up to twelve months, savings account, and money market funds. The cash placed in these accounts earn interest for the business, which is recorded on the income statement as interest income. For some companies, interest income is small or meaningless. For others, such as an insurance company that generates profit by investing the money it holds for policyholders into interest paying bonds, it is a crucial part of the business.

Interest income will fluctuate each year with the amount of cash a company keeps on hand and the general level of interest rates as set by the Federal Reserve (to learn more about how this is done, read The Federal Reserve and Interest Rates.

Interest Expense

Companies often borrow money in order to build plants or offices, buy other businesses, purchase inventory, or fund day-to-day operations. The borrowed money is converted to an asset on the balance sheet (e.g., if a business borrows $1 million to build a distribution center, the distribution center would add $1 million of assets to the balance sheet after the cash was spent.) The interest a company pays to bondholders, banks, and private lenders, on the other hand, is an expense for which it receives no asset. As a result, interest expense must be accounted for on the income statement.

Some income statements report interest income and interest expense separately, while others report interest expense as "net". Net refers to the fact that management has simply subtracted interest income from interest expense to come up with one figure. In other words, if a company paid $20 in interest on its bank loans, and earned $5 in interest from its savings account, the income statement would only show interest expense - net $15.

The amount of interest a company pays in relation to its revenue and earnings is tremendously important. To gauge the relation of interest to earnings, investors can calculate the interest coverage ratio.

Interest Coverage Ratio

Interest Coverage Ratio

The interest coverage ratio is a measure of the number of times a company could make the interest payments on its debt with its earnings before interest and taxes, also known as EBIT. The lower the interest coverage ratio, the higher the company's debt burden and the greater the possibility of bankruptcy or default.

Interest coverage is the equivalent of a person taking the combined interest expense from their mortgage, credit cards, auto and education loans, and calculating the number of times they can pay it with their annual pre-tax income. For bond holders, the interest coverage ratio is supposed to act as a safety gauge. It gives you a sense of how far a company’s earnings can fall before it will start defaulting on its bond payments. For stockholders, the interest coverage ratio is important because it gives a clear picture of the short-term financial health of a business.

To calculate the interest coverage ratio, divide EBIT (earnings before interest and taxes) by the total interest expense.

EBIT (earnings before interest and taxes) ÷ Interest Expense = Interest Coverage Ratio

General Guidelines for the Interest Coverage Ratio

As a general rule of thumb, investors should not own a stock that has an interest coverage ratio under 1.5. An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations. The history and consistency of earnings is tremendously important. The more consistent a company’s earnings, the lower the interest coverage ratio can be.

EBIT has its short comings, though, because companies do pay taxes, therefore it is misleading to act as if they didn’t. A wise and conservative investor would simply take the company’s earnings before interest and divide it by the interest expense. This would provide a more accurate picture of safety, even if it is more rigid than absolutely necessary.

Depreciation and Amortization on the Income Statement

Depreciation and Amortization

There are two different kinds of depreciation an investor must grapple with when analyzing financial statements. They are accumulated depreciation and depreciation expense. Each is unique, though new investors often confused them. In order to understand why they are important and how they work, we must discuss the terms individually.

Depreciation Expense

According to a major brokerage firm, “Depreciation is the process by which a company gradually records the loss in value of a fixed asset. The purpose of recording depreciation as an expense over a period is to spread the initial purchase price of the fixed asset over its useful life. Each time a company prepares its financial statements, it records a depreciation expense to allocate the loss in value of the machines, equipment or cars it has purchased. However, unlike other expenses, depreciation expense is a "non-cash" charge. This simply means that no money is actually paid at the time in which the expense is incurred.”

An Example of Depreciation Expense

To help you understand the concept, let’s look at an example of depreciation expense:

Sherry’s Cotton Candy Company earns $10,000 profit a year. In the middle of 2002, the business purchased a $7,500 cotton candy machine that it expected to last for five years. If an investor examined the financial statements, they might be discouraged to see that the business only made $2,500 at the end of 2002 ($10k profit - $7.5k expense for purchasing the new machinery). The investor would wonder why the profits had fallen so much during the year.

Fortunately, Sherry’s accountants come to her rescue and tell her that the $7,500 must be allocated over the entire period it will benefit the company. Since the cotton candy machine is expected to last five years, Sherry can take the cost of the cotton candy machine and divide it by five ($7,500 / 5 years = $1,500 per year). Instead of realizing a one-time expense, the company can subtract $1,500 each year for the next five years, reporting earnings of $8,500. This allows investors to get a more accurate picture of how the company’s earning power. The practice of spreading-out the cost of the asset over its useful life is depreciation expense. When you see a line for depreciation expense on an income statement, this is what it references.

This presents an interesting dilemma. Although the company reported earnings of $8,500 in the first year, it was still forced to write a $7,500 check, effectively leaving it with $2500 in the bank at the end of the year ($10,000 profit - $7,500 cost of machine = $2,500 remaining).

The result is that the cash flow of the company is different from what it is reporting in earnings. The cash flow is very important to investors because they need to be ensured that the business can pay its bills on time. The first year, Sherry’s would report earnings of $8,500 but only have $2,500 in the bank. Each subsequent year, it would still report earnings of $8,500, but have $10,000 in the bank because, in reality, the business paid for the machinery up-front in a lump-sum. This is vital because if an investor knew that Sherry had a $3,000 loan payment due to the bank in the first year, he may incorrectly assume that the company would be able to cover it since it reported earnings of $8,500. In reality, the business would be $500 short.* There have been cases of companies going bankrupt even though they were reporting substantial profits.

This is where the third major financial report, the cash flow statement, comes into an investor's analysis. The cash flow statement is like a company’s checking account. It shows how much cash was

spent and generated, at what time, and from which source. That way, an investor could look at the income statement of Sherry’s Cotton Candy Company and see a profit of $8,500 each year, then turn around and look at the cash flow statement and see that the company really spent $7,500 on a machine this year, leaving it only $2,500 in the bank. The cash flow statement is the focus of Investing Lesson 5.

Accounting for Depreciation Expense in Your Income Statement Analysis

Some investors and analysts incorrectly maintain that depreciation expense should be added back into a company’s profits because it requires no immediate cash outlay. In other words, Sherry wasn’t really paying $1,500 a year, so the company should have added those back in to the $8,500 in reported earnings and valued the company based on a $10,000 profit, not the $8,500 figure. This is incorrect (honestly, I'm being polite - it's idiotic). Depreciation is a very real expense. Depreciation attempts to match up profit with the expense it took to generate that profit. This provides the most accurate picture of a company’s earning power. An investor who ignores the economic reality of depreciation expense will be apt to overvalue a business and find his or her returns lacking. As one famous investor quipped, the tooth fairy doesn't pay for a company's capital expenditure needs. Whether you own a motorcycle shop or a construction business, you have to pay for your machines and tools. To pretend like you don't is delusional.

*Depreciation expenses are deductible but the tax laws are complex. In many cases, a company will depreciate their assets to the IRS far faster than they do on their income

statement, resulting in a timing difference. In other words, a machine may be worth $50,000 on the GAAP financial statements and $10,000 on the IRS tax statements. To adjust

for this, accounting rules setup a special $40,000 "deferred tax asset" account on the balance sheet that will naturally work itself out by the time the asset has been fully

depreciated down to scrap value. You don't really need to know that for now, but for those of you who get really excited about this sort of thing, I thought I'd throw it in there.

Accumulated Depreciation

Accumulated Depreciation

If you purchased a new car for $50,000 and resold it three years later for $30,000, you would have experienced a $20,000 loss on the value of your asset. As you just learned in the last section, a business would write a portion of this loss of value off each year, even though it required no cash outlay, reducing reported profits.

The accounting entry has to be put somewhere on the financial statements. It is kept in a special type of account (known as a contra account) on the balance sheet known as accumulated depreciation. Frankly, you don't need to worry about that. You just need to know that your balance sheet is going to look like this:

Car Asset - $50,000 value Accumulated Depreciation - Car - ($20,000 value) Net Asset Value - Car: $30,000

As you can see, the purpose of the accumulated depreciation account is to reduce the carrying value of an assets to reflect the loss of value due to wear, tear, and usage. Companies purchase assets such as computers, copy machines, buildings, and furniture, all of which lose value each day. This depreciation loss must be accounted for in the company's financial statements in order to give shareholders the most accurate portrayal of the economic realty of the business.

If you have trouble understanding the concept of accumulated depreciation, think about the problem this way: If a company bought $100,000 worth of computers in 1989 and never recorded any depreciation expense, the balance sheet would still show an asset worth $100,000. Do you really think that computers that old, which wouldn't even run today's software, are worth anywhere near that amount? At most, you'd be lucky to get a few hundred dollars for scrap parts.

Accumulated Depreciation - Net

When you look at a balance sheet, you aren't going to see the individual assets and many businesses don't even bother to show you the accumulated depreciation account at all. Instead, they show a single line called "Property, Plant, and Equipment - net" it is referring to the fact that the company has deducted accumulated depreciation from the purchase price of the company's assets. To see the amount of those depreciation charges, you will probably have to delve into the annual report or 10K.

Once the asset has become worthless or is sold, both it and the matching accumulated depreciation account are removed from the balance sheet. Any gain or loss above the book value, or carrying value, is recorded according to specific accounting rules depending on the situation. If, for instance, the car we discussed above sold for $27,000 despite having a carrying value of $30,000, a business would record a $3,000 loss, adjusted for the income tax savings that would result.

Straight Line Depreciation Method

Straight Line Depreciation Method The simplest and most commonly used depreciation method, straight line depreciation is calculated by taking the purchase or acquisition price of an asset subtracted by the salvage value divided by the total productive years the asset can be reasonably expected to benefit the company (called "useful life" in accounting jargon).

Straight Line Depreciation Calculation (Purchase Price of Asset - Approximate Salvage Value) ÷ Estimated Useful Life of Asset

Example: You buy a new computer for your business costing approximately $5,000. You expect a salvage value of $200 selling parts when you dispose of it. Accounting rules allow a maximum useful life of five years for computers. In the past, your business has upgraded its hardware every three years, so you think this is a more realistic estimate of useful life, since you are apt to dispose of the computer at that time. Using that information, you would plug it into the formula:

($5,000 purchase price - $200 approximate salvage value) ÷ 3 years estimated useful life

The answer, $1,600, is the depreciation charges your business would take annually if you were using the straight line method.

Sum of the Years Digits Depreciation and Other Accelerated Depreciation Methods

Accelerated Depreciation Methods

Another way of accounting for depreciation expense is to use one of the accelerated methods. These include the Sum of the Year’s Digits and the Declining Balance (either 150% or 200%] methods. These accelerated depreciation methods are more conservative and, in most cases, accurate. They assume that an asset loses a majority of its value in the first several years of use.

Sum of the Years Digits

To calculate depreciation charges using the sum of the year’s digits method, take the expected life of an asset (in years) count back to one and add the figures together. Example:

10 years useful life = 10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 Sum of the years = 55

In the first year, the asset would be depreciated 10/55 in value (the fraction 10/55 is equal to 18.18%), 9/55 (16.36%) the second year, 8/55 (14.54%) the third year, etc. Going back to our example from the straight-line discussion, a $5,000 computer with a $200 salvage value and 3 years useful life would be calculated as follows:

3 years useful life = 3 + 2 + 1 Sum of the years = 6

Taking $5,000 - $200 we have a depreciation base of $4,800. In the first year, the computer would be depreciated by 3/6ths (50%), the second year, by 2/6 (33.33%) and the third and final year by the remaining 1/6 (16.67%). This would have translated into depreciation charges of $2,400 the first year, $1,599.84 the second year, and $800.16 the third year. The straight-line example would have simply charged $1,600 each year, distributed evenly over the three years useful life.

Double Declining Balance Depreciation Method

Double Declining Balance Depreciation

The double declining balance depreciation method is like the straight-line method on steroids. To use it, accountants first calculate depreciation as if they were using the straight line method. They then figure out the total percentage of the asset that is depreciated the first year and double it. Each subsequent year, that same percentage is multiplied by the remaining balance to be depreciated. At some point, the value will be lower than the straight-line charge, at which point, the double declining method will be scrapped and straight line used for the remainder of the asset’s life (got all that?). An illustration may help.

In our straight-line example, we calculated that a $5,000 computer with a $200 salvage value and an estimated useful life of three years would be depreciated by $1,600 annually. The first year, we have to compare this to the total amount to be depreciated, in this case, $4,800 ($5,000 base - $200 salvage value = $4,800). Dividing $1,600 by $4,800, we discover the straight-line depreciation charge of $1,600 is 33.33% of the total depreciation amount of $4,800. Using this information, we double the 33.33% figure to 66.67%.

In the first year, we would take $4,800 multiplied by .6667 to get a total depreciation charge of approximately $3,200. In the second year, we would take the same percentage (66.67%) and multiply it by the remaining amount to be depreciated. Continuing with the example, we find that $1,600 is the remaining amount to be depreciated at the start of the second year ($4,800 - $3,200 = $1,600). Multiply 1,600 by .6667 to get $1,066. This is the depreciation charge for the second year – or not! Remember that once the depreciation charges dip below the amount that would be charged using the straight-line method, the double declining balance is scrapped and straight line immediately utilized. The straight line method called for charges of $1,600 per year. Obviously, the $1,066 charge is smaller than the $1,600 that would have occurred under straight line. Thus, the deprecation charge for the second year would be $1,600.

For those of you who love algebra, you may find it easier to use this equation:

Double Declining Balance Depreciation Method Formula Depreciation Base * (2 * 100% / Useful Life of Asset in Years)

Comparing Depreciation Methods

Comparing Depreciation Methods

To reinforce what we've learned thus far, here's a look at what the depreciation charges for the same $5,000 computer would look like depending upon the method used (the chart is at the bottom of this page).

Obviously, depending upon which method is used by management, the bottom-line reported profits of a company can vary greatly from year to year. The level of attention an investor must give depreciation depends upon the asset intensity of the business he or she is studying. The more asset-intensive an enterprise, the more attention depreciation should be given. In other words, you should understand the depreciation philosophy behind every management team when you are examining businesses that require huge plants, factories, equipment, and capital expenditure investment. This is much less important when analyzing businesses that are not asset intensive, such as software companies, advertising agencies, or insurance brokers.

If you have two asset intensive businesses, and they are using different depreciation methods, and / or useful lives, you must adjust them so they are on a comparable basis in order to get an accurate picture of how they stack up against each other in terms of profit.

Some managements will report depreciation expense broken out as a separate line on the income statement, while others will be more clandestine about it, including it indirectly through SG&A expenses (for the deprecation costs of desks, for instance). Either way, you should be able to garner the information either through the income statement itself or going through the annual report or 10K.

Benjamin Graham's 3 Recommended Depreciation Questions

In the classic 1934 edition of Security Analysis, Benjamin Graham recommended the investor answer three questions when dealing with the effects of deprecation on a business (paraphrased):

1. Is depreciation reflected in the earnings statement? Today this, is a moot point because GAAP accounting rules require that all companies report depreciation. This was not the case in the past.

2. Is management using conservative and (as much as possible) accurate depreciation rates? Accounting rules allow assets to be written off over a considerable time period. Buildings, for example, can be depreciated anywhere from ten to thirty years, resulting in large differences in charges depending upon the time frame a particular business uses. A company's 10K filing should contain information on the depreciation rates employed by the company.

3. Are the cost or base to which the depreciation rates applied reasonably accurate? A company may set unrealistically high salvage values on its assets, thus reducing the amount of depreciation charges it must take every year.

Comparing Depreciation Methods

Comparing Depreciation Methods

Method Year 1 Year 2 Year 3

Straight Line $1,600.00 $1,600.00 $1,600.00

Sum of the Years $2,400.00 $1,599.84 $800.16

Double Declining Balance $3,200.00 $1,600.00 $0.00

Earnings Before Interest, Tax, Depreciation and Amortization - EBITDA

Earnings Before Interest, Tax, Depreciation and Amortization - EBITDA

EBITDA tells an investor how much money a company would have made if it didn't have to pay interest expense on its debt, taxes, or take depreciation and amortization charges. EBITDA is intended to be an indicator of a company's financial performance, not free cash flow as many investor incorrectly assume, originally coming into existence in the 1980's during the leveraged-buyout frenzy that epitomized the era of greed. The measurement has become so popular that many companies will boast charts and graphs of their increased EBITDA within the first five pages of their annual report. Investors, thinking this is wonderful, get excited about the business because it appears to be growing in leaps and bounds.

In its brilliance, Wall Street regrettably forgot one part of the equation: common sense. Companies do have to pay interest, taxes, depreciation, and amortization. Treating these expenses like they don't exist is the same mentality of the five year old who believes no one can see them when their eyes are closed - while they may enjoy pretending for awhile, the IRS and the banks and bondholders who lent money to the company aren't interested in playing games. When the bills come due, these entities want the money owed to them and can force a company into bankruptcy if they aren't paid.

Still not convinced? Picture this scenario:

A single man in his mid-twenties, earning $30,000 annually, walks into his local bank to get a loan for a new, top-of-the-line BMW. Each year, he pays $8,100 in taxes, reducing his monthly check from $2,500 to $1,825 (for simplicity sake, let's ignore payroll deductions, etc.) He currently has a mortgage payment of $1,100 per month, and a student loan payment of $200 per month. After paying all of these expenses, he has $525 on which to live*.

The loan officer crunches the numbers and comes up with an estimated monthly payment of $750 for the car. The man pulls out his pen to sign the papers. The loan offer looks in confusion after reviewing his information. "Sir," she says, "you only make $525 a month after payments and taxes! You can't afford this loan. Not only can you not afford the payment, you will then have nothing to live on." The man looks confused, "but I make $2,500 per month before my payments and taxes."

See the fallacy? The gentlemen in our example may ignore the loans, but his creditors surely won't. In fact, the officer would probably laugh at him. Sadly, this is exactly what corporations are doing by presenting their EBITDA numbers to investors.

The truth is, in virtually all cases, EBITDA is absolutely, entirely, and utterly useless. It is simply a way for companies that can't make money to dress-up their failures by reporting increased something to investors. When the traditional metric of profit couldn't be attained, they created a new one that made them appear successful.

In the accounting and business world, EBITDA is a firestorm of controversy. There are some who will defend it vehemently, and attempt to ridicule you for even suggesting it isn't worth the time it takes to pronounce the letters. Often, these people will appear to be very intelligent, driven, and professional. Don't worry about it - four hundred years ago, the brightest men on earth thought the world was flat. Smile and say a prayer of thanks because it's folly such as this that presents us with opportunity to profit in the market.

*$2,500 monthly pay - $625 taxes - $1,100 mortgage payment - $200 student loan payment = $525 free cash.

Income Before Tax and Income Taxes

Income Before Tax

After deducting interest payments and, depending on the business, other expenses, you are left with

the profit a company made before paying its income tax bill. This figure allows you to see what the business would have earned if it did not have to pay taxes to the government.

Income Tax Expense

The income tax expense is the total amount the company paid in taxes. This figure is frequently broken out by source (Federal, state, local, etc.) either on the income statement or somewhere in the annual report or 10K.

You should be fairly familiar with the tax laws affecting specific companies and / or business transactions. For instance, say the business you were analyzing just purchased $100 million worth of preferred stock that was paying a 9% yield (we'll talk more about preferred stock later). You could rightly assume the company would receive $9 million a year in dividends on the preferred. If the company had a tax rate of, say, 35%, you may assume that $3.15 million of these dividends are going to be paid to the Uncle Sam. In truth, corporations get an exemption on 70% of the dividends they receive from preferred stock (individuals do not enjoy this luxury). Thus, only $2.7 million of the $9 million in dividends would be subject to taxation. Don't you love this stuff?

Minority Interests - The Cost Method, Equity Method, and Consolidated Method

Minority Interests on the Income Statement

If Federated Department Stores, the owner of Macy's and Bloomingdale, purchased five percent of Saks Fifth Avenue, Inc., common sense tells us that Federated would be entitled to five percent of Saks' earnings. How would Federated report their share of Saks' earnings on their income statement? It depends on the percentage of the company's voting stock Federated owned.

Cost Method (If Federated owned 20% or less)

The company would not be able to report its share of Saks' earnings, except for the dividends it received from the Saks stock. The asset value of the investment would be reported at the lower of cost or market value on the balance sheet. What does that mean?

If Federated purchased 10 million shares of Saks stock at $5 per share for a total cost of $50 million, it would record any dividends received from Saks on its income statement, and add $50 million to the balance sheet under investments. If Saks rose to $10 per share, the 10 million shares would be worth $100 million ($10 per share x 10 million shares = $100 million). The balance sheet would be adjusted to reflect $50 million in unrealized gains, less a deferred tax allowance for the taxes that would be owed if the shares were sold.

On the other hand, if the stock dropped to $2.50 per share, thus reducing the investments to $25 million, the balance sheet value would be written down to reflect the loss with a deferred tax asset established to reflect the deduction that would be available to the company if it were to take the loss by selling the shares.

The point is, the income statement would never show the five percent of Saks' annual profit that belonged to Federated. Only dividends paid on the Saks shares would be shown as dividend income (which is, actually, added to total revenue or sales in most cases). Unless you delved deep into the company's 10K, you may not even realize that the Saks dividend income is included in total revenue as if it were generated from sales at Federated's own stores.

Equity Method (If Federated owned 21-49%)

In most cases, Federated would include a single-entry line on their income statement reporting their share of Saks' earnings. For example, if Saks earned $100 million and Federated owned 30 percent, they would include a line on the income statement for $30 million in income (30% of $100 million), even if these earnings were never paid out as dividends (meaning they never actually saw $30 million).

Consolidated Method (If Federated owned 50+%)

With the consolidated method, Federated would be required to include all of the revenues, expenses, tax liabilities, and profits of Saks on the income statement. It would then include an entry that deducted the percentage of the business it didn't own. If Federated owned 65% of Saks, it would report the entire $100 million in profit, and then include an entry labeled minority interest that deducted the $35 million (35%) of the profits it didn't own.

Unreported or Look Through Earnings

The Importance of Unreported or Look Through Earnings

You'll notice that the cost method, which applies to holdings under 20%, only allows the company to report the cash it actually receives in the form of dividends as income. This can be misleading. If your company owned 15% of Microsoft, for the first 25+ years, you didn't see a dime in dividends, although your 15% share of the earnings was being reinvested in the business on your behalf by management and would have amounted to several billion dollars. Those earnings will subsequently lead to long-term rise in the value of your stock holding, and are therefore very important to your economic future.

Don't believe it? Say you inherit a business that your great-grandfather founded a century ago. At the end of every year, he used some of the business' profits to buy shares of Thomas Edison's company, General Electric. By the time the company came under your control in 2002, it owned 19% of GE's common stock (1,888,600,000 shares). General Electric paid a dividend that year of $0.72 per share. According to GAAP accounting rules, your business could only report the $1,359,792,000 in dividends you received.

However, the year before, General Electric had actually made a profit of $14.6 billion, of which, nineteen percent indirectly belonged to you. Although you could only report $1.36 billion in dividends, you actually have a legal ownership to $2.774 billion in the company's earnings ($1.36 billion were paid out to you as dividends, with the remaining $1.4 billion retained by GE for future expansion). This means that you were not allowed to report more than $1.4 billion in earnings that indirectly belonged to you.

The general logic states that because you never see that money, it shouldn't count as income. This is both misinformed and dangerous. The entire $2.774 billion belongs to you. The portion of the earnings that were not paid out will be reinvested into GE's business and subsequently result in a rise in the stock price. If someone were to value the business, they would include the entire $2.774 billion in their calculation because the entire amount was working to your economic benefit.

In Some Cases, A Huge Portion of a Company's Profits Won't Be Seen on the Income Statement Due to Accounting Rules

Famed investor Warren Buffett referred to these unreported profits as look-through earnings. The successful investor strives to put together a portfolio with the highest possible look-through earnings for each dollar invested. This will result in market-beating returns. In his 1980 Letter to Shareholders of Berkshire Hathaway, Buffett explained that Berkshire's income statement was reporting less than

half of what the company's true economic earnings were due to the rules governing minority interests:

"Our holdings in this [20% or less] category of companies [has] increased dramatically in recent years as our insurance business has prospered and as securities markets have presented particularly attractive opportunities in the common stock area. The large increase in such holdings, plus the growth of earnings experienced by those partially-owned companies, has produced an unusual result; the part of 'our' earnings that these companies retained last year (the part not paid to us in dividends) exceeded the total reported annual operating earnings of Berkshire Hathaway. Thus, conventional accounting only allows less than half of our earnings "iceberg" to appear above the surface, in plain view."

The lesson is clear: You must add the non-reportable earnings of a company's partially owned businesses back into the income statement to come up with an accurate estimate of economic earnings.

Continuing Operations vs. Discontinued Operations

Continuing / Ongoing Operations vs. Discontinued Operations

In the 1990's, Viacom, owner of MTV, VH1, and Nickelodeon, purchased Paramount Studios. To pay for the acquisition, Viacom took on a large amount of debt. The company's Chairman, Sumner Redstone, began selling assets and businesses the company owned in order to help pay down this debt.

Simon & Schuster, a major book publisher, was one of the businesses Viacom decided to let go, ultimately selling it to British media group Pearson PLC for $4.6 billion dollars. How did the deal affect the company's revenue and earnings?

This is where discontinued and ongoing operations come to the rescue. As soon as Viacom sold Simon, it had a pile of cash from the buyer. However, it lost all of the revenue and profit the publisher generated. Viacom's management must somehow warn investors, "Hey, Simon generated [X amount] of our profit and revenue. Since we no longer own the business, you can't plan on us earning this revenue / profit next year". To do that, the Viacom puts an entry on their income statement called "Discontinued Operations". This shows investors money that was earned from businesses that won't be part of the company's holdings for very much longer.

Continuing operations are the businesses the company expects to be engaged in for the foreseeable future.

Net Income from Continuing Operations After all of these expenses are deducted, the investor is left with a figure called net income from continuing operations. This is a calculation of the profit generated by continuing operations during the period covered by the income statement.

Net Income from Discontinued Operations The amount shown on the income statement under discontinued operations is the profit made during the period from the businesses that will not be a part of the company in the future.

Accounting Changes

Generally Accepted Accounting Principles, or GAAP as they are often called, give management a lot of leeway in determining how to report earnings to shareholders. At times, a company may opt to change the way it has accounted for a particular item in the past, which may result in increasing or decreasing the reported profits despite the company actually being in the identical economic position.

Think back to our depreciation discussion. You saw that the same $5,000 computer could cause drastically different reported profit figures in each of the three years depending upon which method management chose. An aggressive manager could take over a company that had been using the sum of the years digits depreciation method and order the accountants to switch to the straight line depreciation method. With a waive of the pen, profits appear to go through the roof, especially if the business is asset intensive. In reality, you and the other shareholders aren't any richer. In fact, it's likely you are poorer because the manager probably got paid a bonus for his new, record breaking profits.

Management is required to disclose accounting changes in the 10K filings. It is tremendously important that you determine if the change was necessary or simply a maneuver to inflate the amount of profit reported to shareholders. If you suspect there are a lot of games going on with the accounting choices, just walk down the road. There are tens of thousands of companies in which you can buy stock, not to mention all of the small businesses you can acquire or start. It's not worth it to be in a partnership with dishonest people.

Preferred Stock

Net Income

By this time, you should run into the net income figure on the income statement. This is the total after-tax profit the business made for the period before required dividend payments on the company's preferred stock.

Why can't we just stop here? It has to do with the nature of preferred stock. Regular cash dividends on common stock are not deducted from the income statement. In other words, if a company made $10 million in profit and paid $9 million in dividends, the income statement would show $10 million, the balance sheet $1 million, and the cash flow statement $9 million in dividends distributed. Preferred stock dividends, on the other hand, are more like debt. That's why many companies include them on the income statement and then report another net income figure known as "net income applicable to common", which you'll learn about on the next page.

Preferred Stock and Other Adjustments

Preferred stock is a mix between regular common stock and a bond. I explained everything a new investor should want to know in The Many Flavors of Preferred Stock.

Each share of preferred stock is normally paid a guaranteed, relatively high dividend and has first dibs over common stock at the company's assets in the event of bankruptcy. In exchange for the higher income and safety, preferred shareholders miss out on large potential capital gains (or losses). Owners of preferred stock generally do not have voting privileges.

The terms of preferred shares can vary widely, even when issued by the same company. Some of the many different kinds of preferred stock available are: adjustable rate preferred stock, convertible preferred stock, first preferred stock, participating preferred stock, participating convertible preferred stock, prior preferred stock, and second preferred stock.

The dividends paid to preferred shares are deducted from net income because they are required payments, unlike the common stock dividend which is just a divvying-up part of the profits.

Net Income Applicable to Common Shares

The net income applicable to common shares figure is the bottom-line profit the company reported that belongs to its stockholders (owners). It is the starting point for calculating the earnings per share figure you always hear about on the news or in annual reports. To get the basic earnings-per-share

(Basic EPS), analysts divide the net income applicable to common by the total number of shares outstanding.

The last line, at the bottom of the income statement is the amount of money the company purports to have made (net income, total profit, or reportable earnings ... it's all the same). Hence the cliché, "what's the bottom line?"

Many people mistakenly believe that a higher net income figure each year means the company is doing well. The problem with this approach is that it ignores changes in capital at work. In other words, if the company's Board of Directors push for the firm to issue lots of new stock and they double the total money at work in the business but profits only rise 5%, that's a horrible return. That's the sort of thing we're going to discuss further into this lesson because as a new investor, the slavish devotion to constantly rising earnings per share without any attention given to return on capital is one of the most common mistakes you'll need to combat.

Net Profit Margin

The profit margin tells you how much profit a company makes for every $1 it generates in revenue or sales. Profit margins vary by industry, but all else being equal, the higher a company's profit margin compared to its competitors, the better.

Calculating Net Profit Margin

To calculate net profit margin, several financial books, sites, and resources tell an investor to take the after-tax net profit divided by sales. While this is standard and generally accepted, some analysts prefer to add minority interest back into the equation, to give an idea of how much money the company made before paying out to minority "owners". Either way is acceptable, although you must be consistent in your calculations. All companies must be compared on the same basis.

Option 1: Net Income After Taxes ÷ Revenue = Net Profit Margin

Option 2: (Net Income + Minority Interest + Tax-Adjusted Interest) ÷ Revenue

In some cases, lower profit margins represent a pricing strategy. Some businesses, especially retailers, may be known for their low-cost, high-volume approach. In other cases, a low net profit margin may represent a price war which is lowering profits, as was the case with the computer industry way back in 2000.

Net Profit Margin Example

In 2009, Donna Manufacturing sold 100,000 widgets for $5 each, with a cost of goods sold of $2 each. It had $150,000 in operating expenses, and paid $52,500 in income taxes. What is the net profit margin?

First, we need to find the revenue or total sales. If Donna's sold 100,000 widgets at $5 each, it generated a total of $500,000 in revenue. The company's cost of goods sold was $2 per widget; 100,000 widgets at $2 each is equal to $200,000 in costs. This leaves a gross profit of $300,000 ($500k revenue - $200k cost of goods sold). Subtracting $150,000 in operating expenses from the $300,000 gross profit leaves us with $150,000 income before taxes. Subtracting the tax bill of $52,500, we are left with a net profit of $97,500.

Plugging this information into our formula, we get:

$97,500 net profit ÷ $500,000 revenue = 0.195 net profit margin

The answer, 0.195 [or 19.5%], is the net profit margin. Keep in mind, when you perform this calculation on an actual income statement, you will already have all of the variables calculated for you. Your only job is to put them into the formula. (Why then did I make you go to all the work? I just wanted to make sure you've retained everything we've talked about thus far!)

Basic vs. Diluted Earnings per Share - Basic EPS - Diluted EPS

Cherry Pie: Basic vs. Diluted Earnings per Share

When you analyze a company, you have to do it on two levels, the “whole company” and the “per share”. If you decide ABC, Inc. is worth $5 billion as a whole, you should be able to break it down by simply dividing the $5 billion price tag by the number of shares outstanding. Unfortunately, it isn’t always that simple.

Think of each business you analyze as a cherry pie and each share of stock as a piece of that pie. All of the company’s assets, liabilities, and profits are represented by the pie as a whole. ABC’s pie is worth $5 billion. If the baker (management) slices the pie into 5 pieces, each piece would be worth $1 billion ($5 billion pie divided into 5 pieces = $1 billion per slice). Obviously, any intelligent connoisseur of pastries would want to keep the baker from making too many slices so his or her piece was as big as possible. Likewise, an ambitious investor hungry for returns is going to want to keep the company from increasing the number of shares outstanding. Every new share management issues decreases the investor’s “piece” of the assets and profits a tiny bit. Over time, this can make a huge difference in how much the investor gets to eat (in this case, take out in the form of cash dividends).

“How can management increase the number of shares outstanding?” you ask. There are four big knives (perhaps “cleavers” would be a more appropriate term) in any management’s drawer that can be used to increase the number of shares outstanding:

stock options, warrants, convertible preferred stock, and secondary equity offerings

All four of these sound more complicated than they are.

Stock options are a form of compensation that management often gives to executives, managers, and in some cases, regular employees. These options give the holder the right to buy a certain number of shares by a specific date at a specific price. If the shares are “exercised” the company issues new stock. Likewise, the other three cleavers have the same potential result – the possibility of increasing the number of shares outstanding.

This situation leaves Wall Street with the problem of how much to report for the earnings per share figure. In response, the accountants created two sets of EPS numbers: Basic EPS and Diluted EPS.

The basic EPS figure is the total earnings per share based on the number of shares outstanding at the time. The diluted EPS figure reveals the earnings per-share a business would have generated if all stock options, warrants, convertibles, and other potential sources of dilution that were currently exercisable were invoked and the additional shares printed resulting in an increase in the total shares outstanding. The percentage of a company that is represented by these possible share dilutions is called “hang”.

Although ABC may have 5 shares outstanding today, it may actually have the potential for 15 shares outstanding during the next year. Valuation on a per-share basis should reflect the potential dilution to each share. Although it is unlikely all of the potential shares will be issued (the stock market may fall, meaning a lot of executives won’t exercise the stock options, for example), it is important that you value the business assuming all possible dilution that can take place will take place. This practiced conservatism can mean the difference between mediocre and spectacular returns on your investment.

At the bottom of the page is an excerpt from Intel’s 2001 income statement. In 2000, the difference between Intel’s basic and diluted EPS amounted to around $0.06. If you consider the company has over 6.5 billion shares outstanding, you realize that dilution is taking more than $390 million in value from current investors and giving it to management and employees. That is a huge amount of money.

Table INTEL-1

IntelExcerpt - 2001 Annual Report

Earnings per share from continuing operations 2001 2000

Basic EPS $0.19 $1.57

Diluted EPS $0.19 $1.51

Hiding Share Dilution (Including Underwater Stock Options)

Finding Hidden Potential Share Dilution

According to accounting rules, companies don't include the possible share dilution from options that are "underwater". This occurs when an employee owns options to buy shares at a certain price, and due to a sudden drop in stock market value, the option is below the exercise price. If, and this is a big if, the stock does not rise over the exercise price, the option will expire worthless. On the other hand, if the stock advances to higher levels, these options will probably be exercised, increasing the number of shares outstanding, and dilution your percentage ownership in the business.

From a mathematical standpoint, it makes sense not to exclude the underwater options in the diluted earnings per share figure because they would be "anti-dilutive". That is, the price that the option holder paid would exceed the market value of the stock resulting in the company collecting more money than the shares were worth on the stock exchange. For the investor, you need to keep the level of underwater options in mind as you look at a potential investment because most options have extended lives, sometimes as long as 10 years. In that time, it is very likely if not certain that some of those options will become valuable once the company's stock price rises. Thus, a company with a lot of underwater potential dilution could look cheap on paper but as the stock rises, find itself treading water for years as a result of an ever-increasing total of shares outstanding.

An Example of Underwater Options

I'm going to take one of my favorite investments, Abercrombie & Fitch. Both I and companies in which I have major investments have traded in the common stock and derivatives based upon the firm. I'm also going to reach nearly a decade into the past to illustrate my point instead of using current data and making you believe I have an opinion about a particular company one way or the other.

According to Abercrombie's past 10K filings with the Securities and Exchange Commission, "Options to purchase 5,630,000, 9,100,000 and 5,600,000 shares of Class A Common Stock were outstanding at year-end 2001, 2000 and 1999, respectively, but were not included in the computation of net income per diluted share because the options' exercise prices were greater than the average market price of the underlying shares."

As you analyze companies, you must keep your eye out for unusually large potential dilution. Anything more than 2% or 3% of shares should raise your eyebrows.

Share Repurchase Programs

Share Repurchase Programs and Stock Buy Backs

Just as stock options, warrants, and convertible preferred issues can dilute your ownership in a company, share repurchase plans can increase your ownership by reducing the number of shares outstanding. Below is a reprint of an article I published several years ago that talks about how share repurchases and stock buybacks can increase your wealth if they are managed wisely.

Stock Buybacks - The Golden Egg of Shareholder Value "Overall growth is not nearly as important as growth per share…"

All investors have no doubt heard of corporations authorizing share buyback programs. Even if you don't know what they are or how they work, you at least understand that they are a good thing (in most situations). Here are three important truths about these programs - and most importantly, how they make your portfolio grow.

Principle 1: Overall Growth is not nearly as important as Growth per Share

Too often, you'll hear leading financial publications and broadcasts talking about the overall growth rate of a company. While this number is very important in the long run, it is not the all-important factor in deciding how fast your equity in the company will grow. Growth in the diluted earnings per share is.

A simplified example may help. Let's look at a fictional company:

Eggshell Candies, Inc. $50 per share 100,000 shares outstanding ------------------------------------------- Market Capitalization: $5,000,000

This year, the company made a profit of $1 million dollars. ================================== In this example, each share equals .001% of ownership in the company. [100% divided by 100,000 shares.]

Management is upset by the company's performance because it sold the exact same amount of candy this year as it did last year. That means the growth rate is 0%! The executives want to do something to make the shareholders money because of the disappointing performance this year, so one of them suggests a stock buyback program. The others immediately agree. The company will use the $1 million profit it made this year to buy stock in itself.

The very next day, the CEO goes and takes the $1 million dollars out of the bank and buys 20,000 shares of stock in his company. (Remember it is trading at $50 a share according to the information above.) Immediately, he takes them to the Board of Directors, and they vote to destroy those shares so that they no longer exist. This means that now there are only 80,000 shares of Eggshell Candies in existence instead of the original 100,000.

What does that mean to you? Well, each share you own no longer represents .001% of the company... it represents .00125%. That's a 25% increase in value per share! The next day you wake up and discover that your stock in Eggshell is now worth $62.50 per share instead of $50. Even though the

company didn't grow this year, you still made a twenty five percent increase on your investment. This leads to the second principle.

Principle 2: When a company reduces the amount of shares outstanding, each of your shares becomes more valuable and represents a greater percentage of equity in the business.

If a shareholder-friendly management such as this one is kept in place, it is possible that someday there may only be 5 shares of the company, each worth one million dollars. When putting together your portfolio, you should seek out businesses that engage in these sort of pro-shareholder practices and hold on to them as long as the fundamentals remain sound. One of the best examples is the Washington Post, which was at one time only $5 to $10 a share. It has traded as high as $650 over the past few years. That is long term value!

Principle 3: Stock Buybacks are not good if the company pays too much for its own stock!

Even though stock buybacks and share repurchases can be huge sources of long-term profit for investors, they are actually harmful if a company pays more for its stock than it is worth or uses money it cannot afford to spend. In an overpriced market, it would be foolish for management to purchase equity at all, even in itself. Instead, the company should put the money into assets that can be easily converted back into cash. This way, when the market moves the other way and is trading below its true value, shares of the company can be bought back up at a discount, giving shareholders maximum benefit.

Remember, "even the best investment in the world isn't a good investment if you pay too much for it".

Return on Equity (ROE)

Return on Equity - ROE

One of the most important profitability metrics is return on equity (or ROE for short). Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. If you think back to lesson three, you will remember that shareholder equity is equal to total assets minus total liabilities. It's what the shareholders "own". Shareholder equity is a creation of accounting that represents the assets created by the retained earnings of the business and the paid-in capital of the owners.

Why Return on Equity Is Important

A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company's return on equity compared to its industry, the better. This should be obvious to even the less-than-astute investor If you owned a business that had a net worth (shareholder's equity) of $100 million dollars and it made $5 million in profit, it would be earning 5% on your equity ($5 ÷ $100 = .05, or 5%). The higher you can get the "return" on your equity, in this case 5%, the better.

Formula for Return on Equity The formula for Return on Equity is:

Net Profit ÷ Average Shareholder Equity for Period = Return on Equity

Return on Equity Example

Take a look at the same financial statements I've provided from Martha Stewart Living Omnimedia at the bottom of the page. Now that we have the income statement and balance sheet in front of us, our only job is to plug a the numbers into our equation. The earnings for 2001 were $21,906,000 (because the amounts are in thousands, take the figure shown, in this case $21,906, and multiply by 1,000. Almost all publicly traded companies short-hand their financial statements in thousands or millions to save space). The average shareholder equity for the period is $209,154,000 ([$222,192,000 + 196,116,000] ÷ 2]).

Let's plug the numbers into the formula.

$21,906,000 earnings ÷ $209,154,000 average shareholder equity for period = 0.1047 return on equity, or 10.47%

This 10.47% is the return that management is earning on shareholder equity. Is this good? For most of the twentieth century, the S&P 500, a measure of the biggest and best public companies in America, averaged ROE's of 10% to 15%. In the 1990's, the average return on equity was in excess of 20%. Obviously, these twenty-plus percent figures probably won't endure forever. In the past few years alone, small and large corporations alike have issued repeated earnings revisions, warning investors they will not meet analysts' quarterly and / or annual estimates.

Return on equity is particularly important because it can help you cut through the garbage spieled out by most CEO's in their annual reports about, "achieving record earnings". Warren Buffett pointed out years ago that achieving higher earnings each year is an easy task. Why? Each year, a successful company generates profits. If management did nothing more than retain those earnings and stick them a simple passbook savings account yielding 4% annually, they would be able to report "record earnings" because of the interest they earned. Were the shareholders better off? Not at all; they would have enjoyed heftier returns had the earnings been paid out as cash dividends. This makes obvious that investors cannot look at rising per-share earnings each year as a sign of success. The return on equity figure takes into account the retained earnings from previous years, and tells investors how effectively their capital is being reinvested. Thus, it serves as a far better gauge of management's fiscal adeptness than the annual earnings per share.

Variations in the Return on Equity Calculation

The return on equity calculation can be as detailed as you desire. Most financial sites and resources calculate return on common equity by taking the income available to the common stock holders for the most recent twelve months and dividing it by the average shareholder equity for the most recent five quarters. Some analysts will actually "annualize" the recent quarter by simply taking the current income and multiplying it by four. The theory is that this will equal the annual income of the business. In many cases, this can lead to disastrous and grossly incorrect results. Take a retail store such as Lord & Taylor or American Eagle, for example. In some cases, fifty-percent or more of the store's income and revenue is generated in the fourth quarter during the traditional Christmas shopping period. An investor should be exceedingly cautious not to annualize the earnings for seasonal businesses.

If you want to really understand the depths of return on equity, you need to open a new browser, leave this lesson in the background, and go read Return on Equity - The DuPont Model. This article will explain the three things that drive ROE and how you can focus on each one to increase your business or determine how safe growth is in another company; you could, for instance, figure out if recent improvements in profits were due to rising debt levels instead of better performance by management.

Excerpts from MSO Financial Statements

Martha Stewart Living Omnimedia, Inc.Excerpt - 2001 Consolidated Balance Sheet

(In thousands except per share data) 2001 2000

Total Shareholders' Equity 222,192 196,116

Total Liabilities and shareholders' equity 311,621 287,414

Asset Turnover

Calculating Asset Turnover

The asset turnover ratio calculates the total revenue for every dollar of assets a company owns. To calculate asset turnover, take the total revenue and divide it by the average assets for the period studied. (Note: you should know how to do this. In lesson 3 we took the average inventory and receivables for certain equations. The process is the same. Take the beginning assets and average them with the ending assets. If XYZ had $1 in assets in 2000 and $10 in assets in 2001, the average asset value for the period is $5 because $1+$10 divided by 2 = $5.) A quick exercise would benefit your understanding.

Asset Turnover = Total Revenue ÷ Average Assets for Period

In 2001 and 2000, Alcoa (Aluminum Company of America) had $28,355,000,000 and $31,691,000,000 in assets respectively, meaning there were average assets of $30,023,000,000 ($28.355 billion + $31.691 billion divided by 2 = $30.023 billion). In 2001, the company generated revenue of $22,859,000,000. When applied to the asset turnover formula, we find that Alcoa had a turn rate of .76138. That tells you that for every $1 in assets Alcoa owned during 2001, it sold $.76 worth of goods and services.

$22,859,000,000 revenue ÷ $30,023,000,000 average assets for period = .76138, or $0.76 for every $1 in revenue

General Rules for Calculating Asset Turnover

There are several general rules that should be kept in mind when calculating asset turnover. First, asset turnover is meant to measure a company's efficiency in using its assets. The higher the number, the better, although investors must be sure compare a business to its industry. It is fallacy to compare completely unrelated businesses. The higher a company's asset turnover, the lower its profit margin tends to be (and visa versa).

Alcoa Financial Statement Excerpts

Alcoa2001 Income Statement Excerpt

Period Ending Dec 31, 2001 Dec 31, 2000 Dec 31, 1999

Total Revenue $22,859,000,000 $23,090,000,000 $16,447,000,000

Cost of Revenue $17,857,000,000,000 $17,342,000,000 $12,536,000,000

Gross Profit $5,002,000,000 $5,748,000,000 $3,911,000,000

Alcoa2001 Balance Sheet Excerpt

Period Ending Dec 31, 2001 Dec 31, 2000 Dec 31, 1999

Long Term Assets

Long Term Investments $1,428,000,000 $1,072,000,000 $673,000,000

Property, Plant and Equipment $11,982,000,000 $14,323,000,000 $9,133,000,000

Goodwill $9,133,000,000 $6,003,000,000 $1,328,000,000

Intangible Assets $674,000,000 $821,000,000 $117,000,000

Accumulated Amortization N/A N/A N/A

Other Assets N/A N/A N/A

Deferred Long Term Asset Charges $1,746,000,000 $1,894,000,000 $1,015,000,000

Total Assets $28,355,000,000 $31,691,000,000 $17,066,000,000

Return on Assets (ROA)

Return on Assets

Where asset turnover tells an investor the total sales for each $1 of assets, return on assets, or ROA for short, tells an investor how much profit a company generated for each $1 in assets. The return on assets figure is also a sure-fire way to gauge the asset intensity of a business. Companies such as telecommunication providers, car manufacturers, and railroads are very asset-intensive, meaning they require big, expensive machinery or equipment to generate a profit. Advertising agencies and software companies, on the other hand, are generally very asset-light (in the case of a software companies, once a program has been developed, employees simply copy it to a five-cent disk, throw an instruction manual in the box, and mail it out to stores).

Return on assets measures a company’s earnings in relation to all of the resources it had at its disposal (the shareholders’ capital plus short and long-term borrowed funds). Thus, it is the most stringent and excessive test of return to shareholders. If a company has no debt, the return on assets and return on equity figures will be the same.

There are two acceptable ways to calculate return on assets.

Option 1: Net Profit Margin x Asset Turnover = Return on Assets

Option 2: Net Income ÷ Average Assets for the Period = Return on Assets

Return on Assets as a Measure of Asset Intensity (or How "Good" a Business Is)

The lower the profit per dollar of assets, the more asset-intensive a business is. The higher the profit per dollar of assets, the less asset-intensive a business is. All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned $0.20 for each $1 in assets. As a general rule, anything below 5% is very asset-heavy (manufacturing, railroads), anything above 20% is asset-light (advertising firms, software companies).

The first option requires that we calculate net profit margin and asset turnover. In most of your analyses, you will have already calculated these figures by the time you get around to return on assets. For illustrative purposes, we’ll go through the entire process using Johnson Controls as our sample business.

Our first step is to calculate the net profit margin. We divide $469,500,000 (the net income) by the total revenue of $18,427,200,000. We come up with 0.025 (or 2.5%).

We now need to calculate asset turnover. We average the $9,911,500,000 total assets from 2001 and $9,428,000,000 total assets from 2000 together and come up with $9,669,750,000 average assets for

the one-year period we are studying. Divide the total revenue of $18,427,200,000 by the average assets of $9,660,750,000. The answer, 1.90, is the total number of asset turns. We have both of the components of the equation to calculate return on assets:

.025 (net profit margin) x 1.90 (asset turn) = 0.0475, or 4.75% return on assets

The second option for calculating ROA is much shorter. Simply take the net income of $469,500,000 divided by the average assets for the period of $9,660,750,000. You should come out with 0.04859, or 4.85%. [Note: You may wonder why the ROA is different depending on which of the two equations you used. The first, longer option came out to 4.75%, while the second was 4.85%. The difference is due to the imprecision of our calculation; we truncated the decimal places. For example, we came up with asset turns of 1.90 when in reality, the asset turns were 1.905654231. If you opt to use the first example, it is good practice to carry out the decimal as far as possible.

Is a 4.75% ROA good for Johnson Controls? A little research shows that the average ROA for Johnson’s industry is 1.5%. It appears Johnson’s management is doing a much better job than the competitors. This should be welcome news to investors.

Johnson Controls Financial Statement Excerpts

Johnson Controls2001 Income Statement Excerpt

Period Ending Sep 30, 2001 Sep 30, 2000 Sep 30, 1999

Total Revenue $18,427,200,000 $17,154,600,000 $16,139,400,000

Cost of Revenue $478,300,000 $472,400,000 $419,600,000

Preferred Stock and Other Adjustments ($8,800,000) ($9,800,000) ($13,000,000)

Net Income Applicable to Common Shares $469,500,000 $462,600,000 $406,600,000

Johnson Controls2001 Balance Sheet Excerpt

Period Ending 2001 2000 1999

Long Term Assets

Long Term Investments $300,500,000 $254,700,000 $254,700,000

Property, Plant and Equipment $2,379,800,000 $2,305,000,000 $1,996,000,000

Goodwill $2,247,300,000 $2,133,300,000 $2,096,900,000

Intangible Assets N/A N/A N/A

Accumulated Amortization N/A N/A N/A

Other Assets $439,900,000 $457,800,000 $457,700,000

Deferred Long Term Asset Charges N/A N/A N/A

Total Assets $9,911,500,000 $9,428,000,000 $8,614,200,000

Total Stockholders' Equity $2,985,400,000 $2,576,100,000 $2,270,000,000

Net Tangible Assets $738,100,000 $442,800,000 $173,100,000

Projecting Future Earnings

We will save most of the discussion on future earnings for our later lesson focusing exclusively on valuing a business. As a caveat, let's cover some of the basic principles:

1. The greatest indicator of the future is the past. If a company has grown at 4% for the past ten years, it is very unlikely it will start growing 6-7% in the future short of some major catalyst. You must remember this, and guard against optimism. Your financial projections should be slightly pessimistic at worst, outright depressing at best. Being masochistic in finance can be very profitable. A Pollyanna-like disposition can cream your personal balance sheet in the long-run.

2. Companies involved in cyclical industries such as steel, construction, and auto manufacturers are notorious for posting $5 earnings per share one year and -$2.50 the next. An investor must be careful not to base projections off the current year alone. He / she would be best served by averaging the earnings over the past tens years, and basing coming up with a valuation based on that figure. For more information, read Valuing Cyclical Stocks: Assigning Intrinsic Value to Businesses with Unsteady Earnings.

Formulas, Calculations and Ratios for the Income Statement

You've learned how to analyze an income statement! In the next couple of pages, we are going to look at the income statements for some companies. Below is a list of the equations we have covered in this lesson. You should memorize them because they will serve you will in your career.

Gross Margin: gross profit ÷ revenue R&D to Sales: R&D expense ÷ revenue Operating Margin: operating income ÷ revenue (also known as operating profit margin) Interest coverage ratio: EBIT ÷ interest expense Net Profit Margin: net income (after taxes) ÷ revenue Return on Equity (ROE): net profit ÷ average shareholder equity for the period Asset Turnover: revenue ÷ average assets for period Return on Assets: Net profit margin * asset turnover or net income ÷ total average assets for the period 1Working Capital per Dollar of Sales: Working Capital ÷ Total Sales 1Receivable Turnover: Net Credit Sales ÷ Average Net Receivables for the Period 1Inventory Turnover: Cost of Goods Sold ÷ Average Inventory for the Period

1These calculations were discussed in Investing Lesson 3: Analyzing a Balance Sheet. They require both the balance sheet and the income statement to calculate.

Putting It Together - Analyzing an Income Statement

At this point, you should have the ability to understand the most common entries on the income statement, calculate and compare gross, operating, and profit margins, examine depreciation policies and put competitors in the same industry on a comparable basis, calculate ROE, ROA, and asset turnover, have a respectable understanding of how businesses account for minority-owned stakes in other companies, explain the difference between basic and diluted earnings-per-share, appreciate share repurchase programs when stock prices are falling, despise share dilution, be able to explain what "underwater" options are, and discuss why EBITDA is a worthless metric. Congratulations! I hope you feel it was time well spent. Although there is always more to learn, you are further ahead than a majority of people who own stocks, mutual funds, or bonds.

In the future, it may help to think of the income statement as following this general outline:

Revenue - Cost of Revenue = Gross Profit Gross Profit - All Operating Expenses = Operating Profit Operating Profit - Interest Expense, Income Taxes, and Depreciation = Net Income from Continuing Operations Net Income from Continuing Operations - Nonrecurring events (extraordinary items, discontinued operations, etc.) = net income Net income - preferred stock and other adjustments = net income applicable to common shares

Abercrombie and Fitch - 2001 Annual Income Statement

Abercrombie & Fitch Financial Statements

Abercrombie & FitchConsolidated Statement of Income

Fiscal year ended 2001 2000 1999

Net Sales $1,364,853 $1,237,604 $1,030,858

Cost of Goods Sold, Occupancy and Buying Costs $806,816 $728,229 $580,475

Gross Income $558,034 $509,375 $450,383

General, Administrative, and Store Operating Expense $286,576 $255,723 $209,319

Operating Income $271,458 $253,652 $242,064

Interest Income, Net ($5,064) ($7,801) ($7,270)

Income Before Taxes $276,522 $261,453 $249,334

Provision for Income Taxes $107,850 $103,320 $99,730

Net Income $168,672 $158,133 $149,604

Net Income Per Share

Basic $1.70 $1.58 $1.45

Diluted $1.65 $1.55 $1.39

Abercrombie & FitchConsolidated Balance Sheets

(Thousands)

Fiscal year ended February 2, 2002 February 3, 2001

Assets

Current Assets

Cash and Equivalents $167,664 $137,581

Marketable Securities $71,220

Receivables $20,456 $15,829

Inventories $108,876 $120,997

Store Supplies $21,524 $17,817

Other $15,455 $11,338

Total Current Assets $405,195 $303,562

Property and Equipment, Net $365,112 $278,785

Deferred Income Taxes - $6,849

Other Assets $239 $381

Total Assets $770,546 $589,577

Let's look at Abercrombie & Fitch, a specialty clothing retailer that has made a name for itself by selling the 'college experience'. The simple business model makes it a good first annual report to read.

As of February 2, 2002, the company operated a 491 stores (309 Abercrombie & Fitch, 148 abercrombie stores tailored to a younger audience, and 34 Hollister Co. stores. Notice that I've included a copy of the balance sheet so we can calculate return on equity, return on assets, etc.

So you can follow along with the math, you need to download a copy of the balance sheet and income statement. I've included them at the bottom of this page or, if you prefer, you can download the color versions.

Gross Margin

The first thing we do is calculate the company's gross margin. Taking the gross profit of $558,034 and dividing it by $1,364,853, we come up with .40996, or almost 41%. Applying the same calculation to previous years, we find that in 2002, company's gross margin was 41.2%, compared with 43.7% in 1999. As a potential owner of the business, you want to find out why the gross margin is falling, and if the trend is expected to continue. If the industry is hit hard by economic conditions, calculate the gross margins over the past three years for Abercrombie's competitors (such as Pacific Sunwear, Gap, or American Eagle) to see if they are experiencing the same problem.

Operating Margin:

We calculate the operating margin as 19.9% during 2001, 20.5% in 2000, and 23.5% in 1999.

Interest Coverage Ratio:

You will notice that the interest income is recorded as net. If you think back to the lesson, you should remember that this means the total interest expense and interest income were added together to offset one another and the resulting figure recorded. In Abercrombie's case, the company recorded -5,064 in interest.

Using this information to calculate the interest coverage ratio, we take the earnings before interest and taxes (EBIT), of $271,458, and divide it by the total interest expense of $5,064. The answer is 53.60. What does this mean? The company can afford to make its interest payments 53+ times. Obviously, it is going to have no problem making its relatively minuscule payments.

Net Profit Margin:

In 2001, Abercrombie had a net profit margin of 12.4%. In 2000, the profit margin was 12.8%, while in 1999, it stood at 14.5%. Once again, this doesn't mean much unless you compare it to the profit margins of competitors. Even then, it may be inaccurate because of pricing strategy; Neiman Marcus may have a higher profit margin than Wal-Mart but both make money.

Return on Equity - ROE

Here's where we get to the juice. To quickly calculate Abercrombie's return on equity, take the average shareholders' equity ($595,434+422,700 ÷ 2) of $509,067 and divide it into the net profit of $168,672. The answer, .3313, or 33.13%, is the return that management is earning on the retained profits. Obviously, your pocketbook will be much faster enriched if you allow the company to retain all of the profits instead of paying them out as dividends (can you reinvest the earnings at 33%? Probably not!)

If both Abercrombie and a competitor were selling for ridiculously cheap, say 3 times earnings, you would want to go with the business that was generating the highest return on shareholder equity.

Considering the average corporation earns between 10% and 15% on its equity, Abercrombie's high ROE should make your mouth water.

Asset Turnover

Taking Abercrombie's average assets of $680,061.5 ($770,546+$589,577 ÷ 2), and dividing it into the total revenue of $1,364,853, we find the company has an asset turn of 2.0. There are several rules that should be kept in mind when calculating asset turnover. First, asset turn is meant to measure a company's efficiency in using its assets. The higher the number, the better, although investors must be sure compare a business to its industry.

Return on Assets

Multiplying the 12.4% net profit margin by the 2.0 asset turn, we get .248, or 24.8% return on assets. Using the second formula, we divide the net income of $168,672 by the $680,061.5 average assets, which we discover is .248 or 24.8%.

Share dilution

As a conservative investor, you should base your valuation on the diluted earnings per share. Unfortunately, if you remember back to our discussion on share dilution, you haven't forgotten the potential dilution that could be caused by underwater options.

If you believe that Abercrombie is undervalued at the current market price and therefore expect the stock to rise, some of these underwater options may become exercisable, reducing the EPS even further. You would be wise to make a provision for these in your valuation. For instance, if you take the net income of $168,672,000 and divide it by the diluted EPS of $1.65, you can see that management estimates the possibility of a total of 102,225,454+ shares outstanding. You may want to add the 5,630,000 underwater shares to this figure, making the fully diluted outstanding shares stand at around 107,855,454. Now, taking the net income of $168,672,000 and dividing it by the true fully diluted figure, you would get diluted EPS of $1.56 instead of $1.65.

Although there is a possibility of these options not being exercised, conservatism can make a big difference to your pocketbook over time.

Final Thoughts on the Company

A quick look at the income statement shows that sales, gross profit, operating profit, and the basic and diluted EPS have increased steadily for the past few years, even though the gross, operating, and profit margins have fallen slightly. These factors, combined with the high return on shareholders' equity should leave an investor fully satisfied with the business. Management has created shareholder value by reinvesting profits at a high rate of return. If the company's shares were to ever trade low enough, an enterprising investor should have no problem holding Abercrombie in their portfolio if the current conditions persists.

Analyzing Brown Safety

Brown Safety Financial Statements

Brown SafetyConsolidated Statement of Income

Fiscal year ended 2001 2000 1999

Net Sales $5,000 $10,000 $20,000

Cost of Goods Sold, Occupancy and Buying Costs $2,500 $5,000 $10,000

Gross Income $2,500 $5,000 $10,000

General, Administrative, and Store Operating Expense $1,000 $1,000 $1,000

Operating Income $1,500 $4,000 $9,000

Interest Income, Net $0 $0 $0

Income from Continuing Operations Before Taxes $1,500 $4,000 $9,000

Investment Income $350,000 $0 $0

Net Income $279,490 $3,400 $7,650

Net Income Per Share

Basic $2.79 $0.03 $0.08

Diluted $2.79 $0.03 $0.08

Brown Safety*, a fictional company, is the manufacturer of safety products such as chemical goggles, fire extinguishers, safety ropes, and scaffolding for construction jobs. I've created the financial statements at the bottom of this page. In 2001, the company reported record EPS of $2.79, up from just $0.03 the year before.

Those of you who looked closely at Brown's income statement may have caught on to my trick. Excellent job. If you didn't, let me explain.

Deteriorating Core Operations

In 1999, Brown had a 38.25% profit margin. In 2000, Brown had a 34.0% profit margin. In 2002, Brown had a 25.5% profit margin. Don't believe me? Look close at the income statement. You will see that each year, the total profit and revenues have been cut in half, while SG&A expenses remained at a steady $1,000, which caused the decreasing profit margin. In the most recent year, Brown only made $1,500 pre-tax from its continuing operations. Assuming a 15% tax rate, the net profit would have worked out to $1,275 had it not been for investment income.

In the most recent year, Brown realized $350,000 in investment income. Without this one-time boost to earnings, the company would have reported EPS of just over $0.01. To drive home what these means, assume Brown is trading at $5 per share (any number will do, this is solely for illustrative purposes). A well-meaning but less-than-astute investor may scan the stock tables one morning and see that Brown is trading at a a p/e ratio of 1.8 ($5 per share ÷ $2.79 EPS). He gets excited, throws up his hands and calls his broker to buy as many shares as possible. At this rate, he'd be earning 55.8% on his investment!

Unfortunately, in a year or so, the investor will have a very unpleasant surprise. If the current decline in the core business persists, the company will report earnings of $0.005 (that's half a penny!) per share. This makes the p/e ratio 1,000. Instead of a 55.8% return on his investment in 2002, the shareholder will earn a pathetic 0.001%. He is going to lose a major portion, if not all, of his investment unless the business has a large portfolio of stocks and bonds that it can distribute to shareholders or continue selling for cash as was the case of the Northern Pipe Line, an oil transportation company managed by the Rockefeller family nearly a century ago. The stock was trading at $65 per share when Benjamin Graham studied the balance sheet and realized the company had bond holdings worth $95 for each share. The value investor tried to convince management to sell the portfolio, but they refused.

Shortly thereafter, he waged a proxy war and secured a spot on the Board of Directors. The company sold its bonds and paid a dividend in the amount of $70 per share.

The Moral

Why the over-simplified example? There will come a day when you are analyzing a business, and on the surface, it will seem that earnings are increasing and management is doing a splendid job. Upon closer examination, you may find that the core business is actually losing money, and all of the reported profits come from one-time events such as the sale of a business unit, real estate, intellectual property, marketable securities, or any other number of assets. Unless you are buying a company because you believe its liquidation value is higher than its current market price, you could be in for a rude awakening when management suddenly doesn't have anything left to sell or the losses in the core business have spiraled out of control.